Will the Fiscal Cliff Hammer Silver?

Having miraculously survived the end of days as predicted by the Mayan calendar, we are now all on the verge of going over the fiscal cliff according to Senate Majority Leader Harry Reid. Negotiations in Washington have not been running smoothly and the debt ceiling is set to be hit on Monday, Dec. 31.

Over the past month, silver, as represented by the iShares Silver Trust , is down over 11%. Against the backdrop of the Federal Reserve and other major central banks pumping cash into the economy, the looming fiscal cliff, the U.S. edging toward the debt ceiling, and increasingly little time to reach a resolution, you would have thought precious metals would be running. Considering the forces at play and how to position yourself is an important exercise.

The fiscal cliffThe fiscal cliff refers to a series of scheduled tax increases and spending cuts that are slated to take effect in 2013 unless an agreement can be reached in Congress. The Congressional Budget Office has considered the impact of going over the fiscal cliff as it stands, stating that such an event will cause a deep recession and the loss of as many as 2 million jobs. The most critical three areas likely to be affected are the looming debt ceiling, the lapsing of various tax relief measures, and the first round of sequestration cuts.

As the calendar turns over, a variety of tax relief measures will end. Amongst those affected are the so-called Bush tax cuts as well as the end of the payroll tax holiday and extended unemployment benefits. Sequestration refers to mandatory spending cuts that were scheduled as a self-imposed threat by Congress if it could not find bipartisan support for some needed belt tightening; no agreement was reached so the cuts are poised to take effect.

Lastly, floating above all of the specific measures is the fact that December brings with it the threat of the U.S. again hitting the debt ceiling. In a recent letter to Congress, Treasury Secretary Geithner wrote: "'I am writing to inform you that the statutory debt limit will be reached on December 31, 2012, and to notify you that the Treasury Department will shortly begin taking certain extraordinary measures authorized by law to temporarily postpone the date that the United States would otherwise default on its legal obligations."'

Congress at workAs the days tick by, and the likelihood of a resolution seems increasingly small, silver should be expected to perform well. Economic uncertainty, like that created by a new recession, tends to favor commodities because they tend to be good stores of wealth. As inflation, global political unrest, and currency shifts affect the value of financial assets, tangible and necessary goods not only maintain their value, but rise in price as the economy works through the challenges. Silver tends to be particularly appealing because it has both intrinsic and industrial value, as is coveted for both purposes.

Under these circumstances, the question becomes how best to invest in silver. While physical silver has a certain appeal, and the dollar values involved are certainly more manageable for most investors than those involved with gold bullion, there tend to be steep commissions and spreads to the spot price that are not attractive - additionally, these must be paid again when you wish to remonetize your reserve. The ETF is a great option for most investors as it avoids some of the vagaries of the futures market, while still tracking silver performance very closely.

The final option is to invest directly in silver companies like Silver Wheaton , Pan American Silver or First Majestic Silver ; the Global X Silver Miners ETF provides diversified access to silver miners but does not allow you to assert any preferences you may have between various options. As a silver investment, Silver Wheaton remains my top pick based on its business model and its reserves. The company is not a miner, but a silver streaming company. Rather than operate mines - that have been subject to ballooning production costs - the company contracts with miners to purchase their production at a predetermined and fixed cost. The company earns the spread between its negotiated average cost and the prevailing price of silver in the market.

Currently, Silver Wheaton has over 800 million ounces of silver reserves at an average cost of just over $4. This gives the company great exposure to silver prices, while allowing it to remain insulated against many of the challenges faced by miners. This allows the company to carry an operating margin of 74% relative to 30% for Pan American and 48% for First Majestic. While the others have very attractive margins, neither is close to that offered by Silver Wheaton.

A soft landingThe probable scenario is that if a resolution is reached, silver prices will dip on the news. This would favor a wait-and-see approach if you believe Congress will ultimately step up. The details of the resolution are critical to understand as well. While a long-term solution may see silver prices continue to fall as the economy recovers, a solution which simply delays the issue could cast the U.S. economy in an even more negative light, driving silver prices up.

Ultimately, while it may be the slightest bit too soon to jump into silver, all signs point to the U.S. going over the fiscal cliff. With the Fed ignoring inflation - which is to say, doing everything it can think of to drive inflation - commodities have a bright longer-term outlook. In the simplest terms, there is limited downside left in silver, and I'm a buyer, even ahead of the last minute deal we are all hoping for from Congress.

If you are looking for a company whose success is determined by the metals market, but without involving itself in the risks of physically mining the metals, then Silver Wheaton provides a unique play on the future of silver. SLW chooses to finance the mining of silver; it has grown sales and net income every year since 2008, and also has increased competitive advantages over its limited peer group. More details about our outlook for Silver Wheaton can be found here in our Motley Fool analyst report.